Overview
This paper aims at demonstrating that both financial risks and environmental constraints might be efficiently addressed at the same time. Internalizing the social values of environmental externalities and directing the risks taken by managers toward productive environmental investments, by means of an appropriate monetary instrument, may help stabilizing the financial system and triggering economic recovery (Hourcade et al. 2012).
The plan proposed and modeled in this paper is an attempt to break the current gordian knot of climate negociations stating that: (1) The urgency of a bold action for the energy transition and against climate risks is widely admitted. (2) Constrained public budgets in developed countries since the beginning of the great recession seem to forbid any ambitious financing plan, at home or abroad. (3) energy-intensive emerging economies disagree on any policy that limits its ability to keep growing at the same pace. (4) The focus of climate negociations on a "price" mechanism has shown its intrinsic limitations in that context (Ellerman and Buchner 2008, Zachman and Von Hirschhausen 2008)
Any new roadmap for successful negociations must take these constraints as given and try to define a new discussion space around them. In our proposal, the central bank would propose carbon certificates (CC) to the banking system, accruing to banks' capital if and only if they can commit to fund low-carbon entrepreneurs. Such a CC inflow helps the bank comply with capital requirements in periods of difficulties or allow them to expand their lending activities in favorable periods of the cycles without breaching the minimum capital adequacy rules (MCAR) of the Basel committee. These CC have a very specific objective: funding a given amount of CO2 reduction. It is justified by a political willingness to cope with climate change and may have macro-economic co-benefits by triggering a green recovery.
This plan rests on four essential features: (1) An agreement on a "value" (not a real "price") of carbon emissions among the countries involved. (2) The use of the central bank's power to create "carbon certificates" backed on this commonly agreed carbon "value". (3) The building of an institutional arrangement between firms, commercial banks and the central bank in order to avoid agency problems and really target emission reductions. (4) The possibility of an exit strategy, once the transition has occured and is self-sustaining.
Methods
The cutting-edge DSGE models developped in the last few years trying to understand the channels of action of monetary policies offer us the analytical tools required for our proposal. We compute the implementation of this plan by embedding a comprehensive and carefully calibrated model of the banking system (inspired by (Benes and Kumhof 2012), (Brand 2012) and (Gertler and Karady 2012)) in a DSGE model of the world economy with an emission circuit (in line with (Heutel 2011)). This unprecedented framework allows for a comparison of the effectiveness of the plan with standard tax or intensity target strategies.
We also argue in favour of the realism of the assumptions made and the overall realism of the proposed plan.
Results
Our model find both strong economic and political support for our proposal.
In particular, if the plan involves pure money creation in the form of those carbon certificates, its carefull implementation is likely to have no inflation impact as it simply compensates avoided climate damages. The necessary conditions for this positive outcome will be discussed in detail.
As long as the financial system is taken into account in the model, our tool is both superior to a carbon tax and an intensity target
The link between the financial risk and the environmental constraint is for the first time analysed in the context of a DSGE model. It gives support to the idea of double benefit to such an environmental tool in terms of financial stability.
Conclusions
Before the 2015 Conference of Parties in Paris, many ideas about “innovative instruments” to finance the energy transition have been put forward. Through a thorough assessment of the main existing proposition and the unique modelization of our own, we bring to the fore the irreducible advantages of a tool which would take the financial system as a core element of the outcome of the negociations.
References
Benes J. and M. Kumhof, The Chicago Plan revisited, IMF Working Paper, August 2012, Issue 202
Brand T., Politique budgétaire en équilibre général : une analyse appliquée à la zone euro, Document de Travail - Centre d'Analyse Stratégique, June 2012, n° 2012 – 07
Ellerman, A. D., Buchner, B. K. (2008). Over-allocation or abatement? A preliminary analysis of the EU ETS based on the 2005–06 emissions data. Environmental and Resource Economics, 41(2), 267-287.
Gertler M. and P. Karadi, A model of unconventional monetary policy, Journal of Monetary Economics, January 2011, Volume 58, Issue 1, Pages 17–34
Heutel, G. (2012). How should environmental policy respond to business cycles? Optimal policy under persistent productivity shocks. Review of Economic Dynamics, 15(2), 244-264.
Hourcade J. C., B. Perrissin Fabert and J. Rozenberg, Venturing into uncharted financial waters: an essay on climate-friendly finance, International Environmental Agreements: Politics, Law and Economics, May 2012, Volume 12, Issue 2, pp 165-186
Zachmann, G., Von Hirschhausen, C. (2008). First evidence of asymmetric cost pass-through of EU emissions allowances: Examining wholesale electricity prices in Germany. Economics Letters, 99(3), 465-469.